With news that the federal government is planning to abolish negative gearing, it is important that people understands fully what this process is all about.

Negative gearing is a form of financial leverage where an investor borrows money to invest and the gross income generated by the investment is less than the cost of owning and managing the investment, including depreciation and interest charged on the loan (but excluding capital repayments). The investment generates a tax-deductible loss until the income rises to exceed the costs, or the asset is sold, at which point any capital gain made is taxable.

Losses from negatively geared property investments, share investments, and other commercial business ventures are tax-deductible against other taxable personal income in Australia.

In Australia, negative gearing often refers to borrowing to purchase a residential property investment (e.g. a house or unit), which is made available for rent. In some cases the rent received is less than the costs incurred by the landlord (mortgage interest, depreciation and other expenses), resulting in negative gearing.

Borrowing to purchase shares whose dividends fall short of interest costs is another example of a negatively geared investment. A common type of loan to finance such a transaction is called a margin loan. Importantly the tax treatment is the same, and any investment made where the funding costs exceed the income return is referred to as negatively geared.

Negative gearing by property investors reduced personal income tax revenue in Australia by $600 million in the 2001-02 tax year, $3.9 billion in 2004-05 and $13.2 billion in 2010-11.

WITH everyday Aussies finding it increasingly difficult to buy their first home, experts often point the finger at one controversial feature of the property market.

It’s one of the most divisive tax issues in the country. Banks, the real estate sector and property investors like it, but many argue it unfairly benefits the rich.

Now, a major inquiry into Australia’s financial system has sounded an ominous warning for the future of the contentious tax break, which could soon make it easier for first home buyers to enter the market.

Negative gearing is a popular tax arrangement used by property investors to reduce the amount of tax they pay on their income.

It goes like this: if the cost of owning an investment property, including interest on mortgage repayments, is greater than the rental income on that property, the loss can be used as an offset against other taxable income such as your salary.

Opponents argue it distorts the housing market, pushing prices up and forcing first home buyers to compete with already-wealthy investors — and that position appears to have been given some weight by the release of the long-awaited Financial System Inquiry final report.